Should you invest in ARM Holdings?
This post aims to explore the company ARM Holdings, their business model and potential threats and opportunities in the future. Throughout the post I consider a number of resources, such as the 2015 Annual Report and the news website Bloomberg. In the summary at the end I will provide my own opinion on the investment.
ARM (Advanced Reduced Instruction Set Computing Machines) Holdings, is an electronic chipmaker based in Cambridge, UK. Acorn chip engineers founded the company in 1990 to assist Apple in building their first handheld computer, Newton. The project was unsuccessful, however shortly afterwards ARM entered into a licensing agreement with Nokia. From the success of the Nokia 6110 ARM become one of the largest players in mobile chip manufacturing. Currently ARM’s main market segments are mobile computing, network infrastructure, servers and embedded digital devices (the Internet of Things – IoT). Currently 50 per cent of smartphones contain ARM’s latest ARMv8-a chip.
ARM Holdings produces chip designs and is the biggest producer of microchips for mobile devices. ARM licenses its designs to ‘partners’, such as Apple, Google, Microsoft and Samsung, who either pay a yearly subscription for access to the designs or a royalty for each product sold. This royalty is typically ¢5 to ¢10 per device, depending on the device. ARM does not manufacture chips.
This business model is a win-win for ARM and its partners, as ARM can focus on redesigning chips whilst the partners only need to pick one of the latest chip models and then adjust it to suit their needs. As a result partners, such as Apple, are not required to ‘reinvent the wheel’ every time they need a new chip for a product. It is estimated they save hundreds of millions of dollars a year licensing from ARM.
ARM’s share price is currently 1,701p, having risen from 970p in July (+75%), on the back of the announcement of its merger with Softbank.
- Price to earnings is 70.54, indicating a growth stock, but also implying a tendency towards being overbought.
- Dividend is currently 8.78p a share, representing a current yield of 0.55%. The dividend has, however, grown at a consistent average annual rate of +30% a year since 2010.
- ARM also returns cash to shareholders through a share buyback program, roughly worth the same as the dividend.
- 2015 revenues of $1.48bn, up 15 per cent YoY.
- Gross profit margin = 95%, ARM therefore earns 95 cents for every $1 of revenue.
- Return on Equity = 18.8%, this is above average cost of equity of 10% indicating efficient return for shareholders.
- Acid Test of 3.21. This is one of the largest acid ratios I’ve seen, indicating a comfortable capability to repay immediate debts should the company experience financial distress.
From the financials we can draw a number of rudimentary conclusions. ARMs share price may be a little overbought, which is unsurprising considering the recent merger with Softbank, and the dividend is particularly low yielding, however they are increasing share buybacks to compensate for this and the percentage growth is notable. Furthermore they make generous gross profit margins, likely due to the lack of a manufacturing process, and the return on equity is sufficient to justify an investment (below 10% would indicate poor return to funds). The high acid ratio indicates the company has a strong liquidity profile.
ARM has a number of competitors, the largest being Intel. Intel also designs microchips, but unlike ARM it is simultaneously involved in their production. Therefore compared to the $5 to $30 ARM receives, Intel can earn up to $4,616 a chip. Intel is a main competitor because of its scale and aggressiveness. Intel missed out on the mobile phone revolution, deciding to focus on network servers and PC processors instead. This has been profitable, but also means they have yet to make a significant push into the mobile space. Known for their aggressive marketing tactics Intel could damage ARM’s market share. ARM has a lot to lose, with a market share of 95 per cent in the smartphone market.
Future growth and the Internet of Things
ARM Holding’s growth cannot be understated. Revenues have doubled since 2011, from $785mn to $1,488mn, and the sale of ARM chips has increased +23% 2014 to 2015 to 15bn chips and a global market share of 32 per cent. The company is well positioned in the industry to take advantage of the IoT revolution over the next decade, already producing chips designed for that very purpose. However a slowdown in smartphone sales from some of the largest producers (i.e. Apple) may dent the speed of growth in coming years, and there is no certainty over the size of the IoT and whether it will be the goldmine some analysts suggest. Stuart Chambers, ARM Chairman, mentions this uncertainty in the 2015 Annual Report, and the decision to introduce share buybacks in 2014, rather than offer a very substantial increase in the dividend, reflects the company’s caution in betting too heavily, too soon, on the future. One source of uncertainty is ARMs relatively low 25 per cent stake in the embedded intelligence market, compared to 85+ per cent in mobile, storage and wearable devices. This means an investor looking to bet heavily on IoT may find more lucrative investments in the producers (Tesla, Apple, Google etc.) or chip companies with slightly more attractive valuations (Intel P/E 17.67 compared to ARM 70.54). As a ‘grunt’ ARM is likely to see lower margins than the actual producers of IoT products, akin to clothing makers and clothing stores.
I’m confident for ARM’s future. I think the merger with Softbank will provide an opening in the Asian market, and access to deeper resources. Normally during a merger I would be concerned over sovereignty and whether the company will be ‘milked dry’, however Softbank has given assurances that ARM will perform as normal and receive adequate investment to take advantage of IoT.
Despite this, I won’t be jumping to invest. The uncertainty over growth in the mobile device market, and whether the IoT will be as large as we expect, does not justify investing at a price to earnings of 70.54. I suspect that as the numbers start to emerge from the merger we will gain a better picture of the value of ARM. I further believe with a dividend yield of less than 1% there are stronger yielding, and less ‘overvalued’, alternatives to seek an income on your portfolio.
To put it simply, the current price is too high.